by David Fessler, Investment U Senior Analyst
Tuesday, January 10, 2011: Issue #1681
Crude prices are fundamentally based on supply and demand. Raise the supply or lower demand, and prices retreat. The opposite also holds true.
Oil tankers can take up to one and a half miles to come to a stop, and up to 10 miles to make a u-turn. That’s a long time at the speed of an oil tanker.
The global economy is no different. Economists had hoped the slowdown in the global economy would cause oil prices to retreat. Instead, they’ve gone up.
While demand has slackened here, it’s gone up elsewhere. Long term, demand will continue to increase. In fact, it was just reported yesterday that Goldman Sachs sees China surpassing the United States as the largest oil importer in the next 12 to 18 months.
And as the world’s largest economy (ours) continues to climb out of the canyon we fell into a few years ago, we’ll begin to consume more oil. That will increase demand, putting an upwards bias on prices.
Clearly oil prices are in a constant state of flux. But there are major trends and events that could cause the price to move rather dramatically, mostly in the upward direction.
Let’s take a look at what I believe are the top five:
#1 The Iran/U.S. Powder Keg: Bad News
Right now, there’s a lot of saber rattling by both Iran and the United States over the U.S. decision to impose further sanctions on Iran. The latest involve Iran’s access to customers to sell its oil.
The United States has persuaded major clearing banks to stop doing business with the country. Iran has threatened to shut down the Strait of Hormuz, a move that would cut off a major source of world supply if they were able to accomplish it (they can’t).
However, they could temporarily shut it down, which would cause a sizable spike in oil to at least $150 a barrel, if not more. It all hinges on the length of the shutdown, whether a conflict erupts, etc.
Iran recently announced it would be holding a second set of military maneuvers in the Gulf of Hormuz. This situation could explode at any moment. We’re talking about Ahmadinejad here, and a country whose desperation level is growing by the day.
#2 Libya’s Rapidly Improving Supply Situation: Good News
The prolonged conflict in Libya eventually led to the overthrow of its autocratic leader, Muammar Gaddafi. Unfortunately, during the conflict, 1.6 million barrels per day of world crude sully was off the market.
Every refinery, pipeline and port facility was in shutdown mode during the civil war. The good news is that few of the facilities sustained damage. For those that did, it was relatively minor.
As a result, Libya’s ramping up its oil machine faster than anyone ever anticipated. According to analysts at Commerzbank, Libya should be back to its full pre-war production levels by this June – six months faster than anyone anticipated.
#3 Threat of the Collapse of the Euro: Good News, Bad News
As we mentioned previously, slowing global growth will keep downward pressure on oil prices. The only increase in demand will come from emerging and frontier markets.
But further deterioration in the Euromess would severely weaken the global economy, including those of emerging markets. That could send oil prices plummeting.
However if the Europeans manage to muddle through their financial mess and come out down but not out, oil prices won’t be affected to any great extent by events there. This situation isn’t quite as volatile as Iran, but it bears watching nonetheless.
#4 The Strength (or Lack of it) in the U.S. Dollar: Good News, Bad News
Much to the great dismay of some oil-producing countries, oil is priced and traded in U.S. dollars. Everything else being equal, the price of oil varies in relation to the fluctuation in the value of the dollar.
The two are inversely correlated. When the dollar is up, oil is down. The reverse is also true. The dollar will likely remain strong this year, given all the issues in Europe, and to a lesser extent, Japan.
The fact that crude prices are up in the face of a strong greenback simply highlights the complex interactions of the many factors that affect the price of oil.
#5 Saudi Arabia: No Longer the Supplier of “Last Resort:” Bad News
Throughout modern oil history, there has never been an oil field like the Ghawar field in Saudi Arabia. It’s the largest conventional oil field in the world, measuring 3,230 square miles.
To put that in perspective, that’s nearly three times the size of the state of Rhode Island. It’s entirely owned by Saudi Aramco, the sheikdom’s nationalized oil company.
Estimates of the amount of oil left in Ghawar vary widely, and the actual number is a closely guarded secret known only to Saudi Arabia.
Regardless of the amount left in Ghawar, Saudi Arabia remains the largest exporter of oil in the world. As such, it has a big say in determining the price of oil, simply by changing how much it increases or decreases production.
However, that may soon change. In the wake of the numerous Arab uprisings, Saudi Arabia is spending record amounts of money this year (up 7% over last year) in order to keep its citizenry happy.
That’s not going to be much of a problem, since higher oil prices also mean higher revenue for the country.
But according to Fitch Ratings, the Kingdom’s break-even oil price is $75 per barrel. Anything less than that, and the country would start to run a fiscal deficit. Fitch feels that if the modest spending growth of 7% continues, the country could be in deficit mode as early as 2015.
What does that all mean? Saudi Arabia has a vested interest in seeing oil prices remain high, and it will adjust its output to see that they remain there.
Bottom line is that Saudi Arabia can no longer be counted on to provide more oil whenever Obama or someone else rings them up and asks them to do so. More and more, they will be looking out for themselves.
And what they do end up supplying won’t be cheap.
Unfortunately, the bad news outweighs the good news when it comes to oil this year. You can expect prices to remain high, and they could head much higher if some of the scenarios come to pass. As I recently covered though, investors can help themselves hedge against higher oil prices by buying stake in some of the oil companies that will prosper with higher margins.